Sunday, May 17, 2015

Are You Suffering from Input Overload?
Think Digital, but Judge Analog.


Over the last week or so my wife Ruth and I have been with music lovers, including donors and professional musicians where much of the discussions have focused on the musical scores. The very term leads me to think of financial scores. Both are performance measures and there are well-recognized parallels between music, math/science and investing.

All three cultures contain enormous amounts of individual facts (and fictions masquerading as facts). If we paid complete attention to all of these our constrained brains would become overburdened. Instead we choose to narrow our focus to segments; e.g., nineteenth century symphonies, organic chemistry, or equity mutual funds. Even these segments are too large for individual attention, so we tend to array these participants in a statistical rank order. Thus, we become a captive of the digital world order.

Music favorites

In deciding which rendition of a piece of music is their favorite, people choose based on memories. What we may remember is the total effect of the last time we heard West Side Story or Beethoven's Fifth Symphony, which is the result of the orchestra, conductor, venue, acoustics, and importantly our particular location physically and emotionally. Since the sum total of these digital inputs can not be algebraically experienced, the resulting feeling of satisfaction is an analog reaction.

Successful investment choices

As much as it pains me to admit, my learning as a CFA® charter-holder has provided me with lots of decision inputs, but so far has not been much help in developing consistently winning portfolios.

While I may make imperfect projections of revenues, margins, tax rates, shares outstanding, earnings per share, relative valuations against markets, peers, growth rates, etc., the success of my investing for clients will be an analog of known and more importantly, unknown factors.

Unexpected or unusual combinations of  instruments

In most of our descriptions of Legacy Portfolio investments I have focused on equities or equity funds. However, in the hands of a skilled portfolio constructor/manager I could see the following other types of investments included: long-term commodity shortages, unimproved real estate, long-term TIPS, and currently unpaid royalties. When combined with investments in a combination of secular growers and the beneficiaries of disruption, any or all of these could make beautiful music together in the Legacy, the longest of my Timespan Fund Portfolios.

Question of the week: What lessons can you or have you learned from music?
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Sunday, May 10, 2015

Great Music Can Discipline Good Investing


The global equity surge on Friday was a political relief rally for stock owners.  The rise could restore the rhythm of alternating up and down months, with May being scheduled as an up month.  This cycle could be considered a possible link from the musical world to the investment arena.  Patterns or streaks in the investment world break down eventually, however great classical music goes on forever.  

Recently I was in Europe on a group tour with donors to the New Jersey Symphony  Orchestra (NJSO), and my wife Ruth, who is the orchestra’s Co-Chair. Before the official beginning of the tour we were in Geneva on family-related matters where I noticed a billboard for a concert of the local Orchestre de la Suisse Romande, which is the orchestra for the French speaking portion  of Switzerland. The orchestra’s visiting conductor for the night was Neeme Järvi, formerly the Music Director for the NJSO. We attended the concert and listened to familiar pieces by Franz Schubert and Ludwig van Beethoven which we heard
Maestro Järvi conduct in Newark, New Jersey. When we visited him and a portion of his large, talented family backstage, he was the same genial host we had known.
While in Prague (or spelled locally, Praha) we heard the Parnas Ensemble, a quintet playing highly spirited pieces by Mozart, J.S. Bach,
Dvořák, Bizet, and Brahms. What does this have to do with designing the correct components to an investment portfolio? Many of the pieces we heard were two hundred years old  and yet sounded new and exciting to us, even though we had heard them performed by individual soloists, quartets, quintets, chamber music groups or full symphony orchestras around the world. At each concert highly trained musicians interpreted the pieces in a different way so it was like hearing the music for the first time.

Turning to investment portfolios

Just as the musicians mix various instruments into their pieces, my structure of timespan portfolios can include real estate, commodities, fixed income securities, stocks from around the world, and my specialty mutual funds. A well-thought investment portfolio can be imaginative and fresh to a savvy investor similar to the experience one receives when leaving a concert that has produced evocative interpretations from old musical works. Similarly, a well chosen set of timespan portfolios can fill a deep and newly awakened investment need.   

Inter-relations between timespan portfolios

The structure of the first four portfolios is dependent on each of the Operational, Replenishment, Endowment, and Legacy Portfolios doing its job and relying on subsequent units to do their job. One of our perceptive readers, a professional portfolio manager, and one of my sons, asked the question, “How much of one's wealth should be devoted to each stage?” Unfortunately, there is no set answer.

The continual process of development

One begins sizing the initial timespan portfolio, the Operational Portfolio, with the first version of a funding needs spreadsheet starting with a two year spending budget estimate (including a reasonable contingency factor). Input by the CFO and/or external accountant is critical as well as the real planning officer, often the CEO.

The task of assessing the size of the second portfolio, the Replenishment Portfolio, is to make a somewhat independent judgment of the probability of the timing of the exhaustion of the Operational Portfolio, which is slightly dependent on the expected interest rate and cash flow in that account. This timing will determine the probable schedule of replenishment.

There is no hard math as to the allocation of capital to each of the four separate portfolios. Assuming that spending can be limited to 3% of capital, the Operational Portfolio should get two years of spending or 6% of the total. In the current time period, I am assuming no real income generated over minor administrative expenses will be paid out.

The Replenishment portfolio normally should have a five year timespan during which one should expect at least one period with a 10-20% decline. Making the bold assumption that on average, equity markets continue to rise about 9% per year, it is reasonable to assume that in aggregate, including any decline, they could produce replenishment capital of about 6% of the portfolio value. On the basis of this logic and on assumptions given, the Replenishment Portfolio should represent 50% of the capital of the account, assuming no additional contributions. (If in cash, additional contributions could substitute for some of the estimated rates of return.)

The Endowment Portfolio

Utilizing the above general example, there remains 44% (100% minus 6% minus 50% =44%) to be split between the Endowment and the Legacy Portfolios. How the split is made may be a factor as to how the current generation of senior management perceives the identified long-term needs of the account organization. If the organization has been regularly investing for its future, or if the family grantor perceives that the existing family members will receive enough without ruining their incentives to be productive, the bulk of the 44% might go into the Legacy Portfolio for expected but unknown needs/opportunities.

Even when heavily invested in equities, an endowment account is typically going to be judged on its long-term generation of income, including realized gains. A Legacy Portfolio should be judged on its ability to grow its capital.

Music lessons for investors

There are many ways to hear a great piece of music, but hearing the different approaches gives the listener a broader array of benefits and can lead to different choices for different listening pleasures. The same thing can be said at analyzing different portfolios with some of the same positions. A number of so-called active portfolios might hold shares of Apple, Google and IBM. For sake of discussion, assume that each holding represents 5% of the total portfolio and in aggregate 15%. (I know of no such fund portfolio.) One might expect that portfolios with similar holdings would produce roughly similar results. This is rarely the case, for the other 85% of the portfolio is likely to produce meaningfully different results.

There are many answers as to why funds perform differently. When I was consulting with the independent directors of fund groups trying to judge whether they should renew investment management contracts, I pointed out important differences beyond performance and holdings. I will admit relatively few directors wanted to listen to the whole piece. Some of the elements I mentioned to them were as follows:

1. How well did the managers follow instructions in the prospectus
    and from the board?
2. The impact of differences in fees and expenses.
3. Different flow characteristics.
4. Management of critical personnel + backup development.

Let me over-simplify a comparison of Warren Buffett/Charlie Munger of Berkshire Hathaway and Peter Lynch, the great long-term portfolio manager of Fidelity's Magellan Fund, who had similar performance in some years and from time to time actually owned a portion of the same stocks. Both Buffett/Munger and Lynch had professional disdain toward economic projections, but they each played to different tunes. Buffett relatively through securities he owned, his large positions made him technically an insider with holdings of 10%+ of the voting securities. Because he had the use of the long-term float of other people's capital, he was leveraged. Peter was very conscious that his good investment  performance was bringing to Magellan bundles of capital, with Magellan becoming the first equity fund to have assets of over $100 billion. Peter was very conscious that as easy as the money came in it could go out, as learned by the managers who followed him. The portfolio swelled at one point to perhaps 1800 individual issues, including 130 with the initial name "First" (as in Savings & Loans and Savings Banks). At one point he had three traders working effectively just for Magellan’s accounts.

In assessing investors' risks with these managers, Buffett represents a leveraged, highly concentrated balanced portfolio which he personally owns as a 50% principal in the company. To an extent his favored investment period was and is forever. Magellan was going to be only as good as its short-term performance with a broad equity portfolio.

While these three great minds made great investment music which seemed similar; just as one hears the difference between great orchestras playing from the same score, the results were quite different. A careful analyst of portfolios needs to understand the differences between outcomes and casual features.
Question of the week: What are the differences that you think are important other than past/present outcomes?
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Sunday, May 3, 2015

The Differences Between Endowment and Legacy Portfolios


As I have previously stated, I want to learn every single day. In the last four days I was in meetings with a university investment committee, portfolio managers at Wasatch Advisors and Berkshire Hathaway's annual shareholders’ gathering. In each meeting I learned a great deal about the many institutional applications of my Timespan Fund Portfolios, particularly the Endowment and Legacy Portfolios.  Each has its place. The real difference is that the Endowment Portfolio is designed to fulfill the funding needs during the account-holder’s lifetime, while the grantors of the Legacy Portfolios are looking way beyond their own lifetimes, possibly for multiple generations.

Investment Committee tenures might determine policies

During this period of extraordinary low interest rates and its heightened demand for high quality, non-correlated bonds of lengthy maturities, an intense discussion as to the opportunity to issue long-term bonds is occurring. Some see this as a lost opportunity to issue a large amount of bonds with maturities of up to125 years to match the demographic changes expected, especially the growth in longevity recognized by leading life insurance companies.  

The case for a larger and lengthier bond issue is akin to a legacy portfolio designed to provide strategic capital for yet unidentified  needs. Having survived and prospered from the 2008 crisis in the financial community, I was appreciative of the value of  rapidly deployable large amounts of excess capital. The very fast acquisitions of Bear Stearns and Merrill Lynch are two headline examples of the swift use of strategic capital. A week or so before the expedited closing of these deals by JP Morgan Chase and Bank of America neither bank had an idea that such an opportunity might soon exist. This development  has not yet happened in the academic and scientific communities, but based on some present terms I don't rule it out. (One of my concerns about the future structure of the financial community is that due to the various capital constraints placed on large financial institutions there has been a shrinkage of truly excess capital that can be mobilized in crisis/opportunities.)

The bottom line for those of us who deal with the financial construction for various organizations: it is important to take into consideration the weighted
average tenure of the political leaders.

My other two days were spent with investments that could play a role in Legacy Portfolios.

A Visit to Salt Lake City

Please do not take the following discussion as a recommendation to purchase any Wasatch mutual fund, which should only be considered in the light of your account and what else you own.

Most of Wasatch Advisors funds can be grouped into small market capitalization stock, domestically-oriented funds and similar funds invested in international, emerging, and frontier stock funds. The focus of my visit to this group of fundamentally driven portfolio managers and analysts was to determine whether these funds could be used in legacy-oriented portfolios.

One of the concerns in using small caps in a long-term Legacy Portfolio is the expected market declines; i.e., how much worse would these actively managed small cap funds do in market declines? To answer these concerns they measured the performance of the Wasatch Small Cap Core Growth Fund vs. the Russell 2000 Growth Index for the 100 worst performing days between 12/31/2012 and 3/31/2015. According to their data, in 92% of the worst days the fund performed better than the index. This finding suggests that there is not additional risk in using this fund for long periods which would be typical in legacy accounts.

The other attractive capability in the shop is in an actively managed Emerging Markets Select Fund. This 30-40 stock portfolio is managed flexibly with a bottoms-up approach where selectivity has produced better results than using sectors or country matrices. In general they invest primarily in companies providing goods and services to be consumed in the country or region produced. One of the guiding principles for my Legacy Portfolios is to invest in long lasting, positive to exploding trends beyond the current market cycle. On this basis, the
Emerging Markets Select Fund is one of the types of funds that should be found in a Legacy Portfolio.

The Institutionalization of Berkshire Hathaway

I also attended the annual meeting of Berkshire Hathaway*. In the always amusing and occasionally instructive Warren and Charlie Show, many of the answers to questions asked brought out the following comments by Mr. Buffett or Mr. Munger:

1.  They don't make acquisitions primarily due to macroeconomic factors, they intend to own the acquired companies for a hundred years. They are running the company by making decisions with a one hundred year outlook.

2.  They believe that corporate culture starts at the top; institutionalized integrity is what they are all about.

3.  Warren and Charlie are looking for Berkshire to be an institution that will live and grow well beyond their lives.

Berkshire Hathaway in portfolios

Berkshire could easily fit in both Endowment and Legacy Portfolios. For the Endowment Portfolio,  Berkshire has the potential to produce continuity and broad diversification based on the 80 separate businesses which it owns, an actively managed securities portfolio, and a new aggressively managed private equity partnership of substance.

From a Legacy Portfolio’s standpoint, the current management of Warren and Charlie are future-oriented, demonstrated by their ability to create a direct writing workmen’s compensation insurance company from scratch, major tax subsidized solar and wind based utility revenues, and increased investments that will benefit from the remarkable growth in China.  Berkshire Hathaway is building on to the long-term future.

* Shares of Berkshire Hathaway are owned in our Financial Services Fund and personally.

Question of the week: Do you have elements in your portfolio that would fit in either the Endowment or Legacy Portfolios, or possibly both?

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Comment or email me a question to .

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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.